What Is a Stablecoin?

8 months ago | Peter Wind

What is a stablecoin?

A stablecoin is a crypto asset that is designed to maintain a stable value. In the vast majority of cases, stablecoins are pegged to the value of a fiat currency, with the most popular being the U.S. dollar (USD). The most popular platform for issuing stablecoins is Ethereum, because it is a secure proof-of-work blockchain that makes it easy to create tokens and run smart contracts. Still, the largest stablecoin currently on the market (Tether) runs on Omni, which is a layer built on top of Bitcoin.

How does a stablecoin maintain a stable price?

In most cases, the answer is quite simple. The issuer of a stablecoin guarantees that they will redeem the stablecoins for an equal amount of fiat currency, although this process usually comes with a fee. If the price of a stablecoin drops significantly below its peg, the price should eventually return back to the peg due to arbitrage (this assumes that the stablecoin is fully backed).

To ensure the viability of the system, a stablecoin’s issuer should hold an amount of fiat currency reserves equal to the amount of its stablecoins in circulation. Since blockchain technology provides complete transparency in terms of any given token’s supply, the issuer knows exactly how much they should be holding in reserve.

The issuers of the USDC, GUSD and PAX stablecoins provide monthly reports from third party auditing or accounting firms to show that the designated bank accounts hold enough fiat currency to cover every token in circulation.

Some stablecoins, such as MakerDAO’s DAI, are based on alternative designs. DAI uses ETH as collateral alongside a system of smart contracts, and it has been quite successful so far at maintaining its $1 peg.

At the end of the day, something is only worth as much as someone is willing to pay for it, and stablecoin prices are still vulnerable to fluctuations. Sometimes, they can be drastic, like what we saw with Tether in October of 2018. At one point, the USDT token fell as low as $0.85 on Kraken due to doubts surrounding the banking relationships of USDT’s issuer.

What are stablecoins good for?

At the moment, the most popular use for stablecoins is to facilitate cryptocurrency trading. USDT in particular is accepted by a very large number of exchanges, although alternatives are gaining traction as well. For exchanges that don’t support fiat currency trading, stablecoins present an opportunity to list an asset with a relatively stable value.

Traders can also quickly switch from a volatile cryptocurrency to a stablecoin in order to protect their holdings.

Stablecoins have the potential to bring the benefits of blockchain (censorship resistance, 24/7 operation, global reach) while doing away with the high volatility that is associated with crypto assets. This could make them suitable for use as currencies, although this also depends on how the future turns out in terms of regulations.

Having an asset with a stable value that can seamlessly interact with smart contracts is also an idea with considerable potential – for now, this is particularly interesting for Ethereum-based stablecoins.